GEI Newsletter Issue No. 1

Reforming the International Monetary System: Lessons from the Mexican Experience - by David Vines

Also in this issue:

Editorial
by David Vines
Report on 'The Future of Global Economic Institutions' A Workshop of the Global Economic Institutions Research Programme of the Economic and Social Research Council, London, 22/23 March 1995
by Ray Barrell

Reforming the International Monetary System: Lessons from the Mexican Experience
by David Vines

Back to - 1. Emerging Markets, Volatile International Capital and New Capacities

3. Reform Lessons

I have heard it argued that the above process is more or less inevitable: that liberalization reforms, because they involve the adjustment to a much higher return on capital will involve a large stock adjustment, which will almost certainly be overdone, with inevitable financial adjustments after the event.

The role for systematic reform, if any, involves trying to create a structure in which transitions to open trade and capital movements happen without such wild financial instability. The liberalization process creates an intrinsically risky process of a race between a demand boom and ‘time-to-build’. Sovereign lending – in fixed interest securities on which there is expected to be no default – does not share this risk, and so the liberalising government is highly geared. This appears to be inefficient. Capital structure – contra the Modigliani-Miller theorem – does matter, and the efficient capital structure would involve risk-sharing.

This is in sharp contrast with the way in which the private sector proceeds. First, the private sector raises a mixture of fixed interest and explicitly risk bearing capital, and this shares risk. Second, the possibility of bankruptcy makes private sector fixed interest securities themselves risky. Are these two routes open to sovereign borrowers? If not, what more informal risk-sharing procedures are available?

3.1 Explicitly Risk Bearing Capital

One possibility might be a kind of gearing solution: an outcome in which only a certain proportion of lending to the governments of emerging markets take the form of fixed interest securities and that the remainder be in the form of income contingent loans, or of ‘equity’. Such securities could be constructed by analogy with commodity bonds, with repayment conditional on the outcomes for macroeconomic aggregates in the same way that the value of commodity bonds is conditional on the price of the commodity in question. Of course these would initially be sold at a discount to fixed interest securities, but they would only pay returns in good states of nature, i.e. if the race between the supply side and the demand side described above turned out well. The more this is done the smaller would be the ex-ante exposure to risk in bad times.

3.2 Institutional Mechanisms for Financial Distress: Bankruptcy versus Default

In the absence of sufficient different forms of equity financing, the sovereign borrower will remain subject to a high proportion of fixed interest obligations. There will then be the possibility of bad outcomes in which, on present policies (e.g. tax rates), the government is insolvent. In current circumstances there is a stark alternative currently facing sovereign borrowers in such bad times: either keep paying these fixed interest obligations or face default. This is a stark alternative because the ways of adjusting so as to pay up may be politically impossible (or may endanger other policy objectives, such as by a return to protectionism); and yet default may expose the country to financial panic, collapse, and descent into Hobbesian anarchy.

Another possibility, advocated by Sachs, would be a common and speedy use of ex-post bankruptcy procedures: where borrowing obligations, even if in dollars, and even if sovereign-backed, would be expected to be subject to write-downs much more than is likely at present when the only available option is straight default.

Private sector bankruptcy proceedings involve protection from the harsh outcomes of straight default, in four ways:


(i) protection from an economically inefficient initial ‘grab race’ by creditors, including a stay on interest payments;

(ii) the injection of new temporary ‘working capital’ financing (normally on preferential terms, by providing administrative priority for new creditors);

(iii) enterprise restructuring and the installation of new management; and

(iv) balance sheet write-down.


There are collective action problems with all of these stages, which the bankruptcy proceedings are designed to address. In the absence of such proceedings, i.e. with mere default, then these problems become very difficult to deal with. Should institutional mechanisms be created to address these issues in the case of sovereign borrowers, and if so, how?

Creditor Grab Race

It is necessary to prevent the creditor grab race which is a feature of plain default. In the sovereign debtor case the grab race involves capital outflow. Is it possible to institutionalize mechanisms for dealing with financial distress without the reimposition of capital controls? If not, and if one of the central aspects of liberalization is the removal of such controls, what then? Might not the mere possibility of bankruptcy negotiations make the likelihood of capital outflow all the greater?

Financing

A new financing facility, to be created by increasing the General Agreements to Borrow, is relevant here. It is designed to support an overall package which, without financing, might come unstuck due to liquidity problems.

Such a financing facility will provide what a lender of last resort does for banks in the national banking system, namely the injection of new temporary ‘working capital’ financing. Such a lender of last resort system, to avoid moral hazard as much as possible, should have Bagehot’s three features:

• lending freely to solvent governments
• against good collateral
• at a penalty rate

These points are important. The intention is not to throw this good money after bad (there is an important distinction between financing and the ‘rescue’ discussed below). Thus the use of this money should be conditional on agreement on an adjustment programme. As a result, if properly administered, its use does not create moral hazard, especially given the penalty rate to be charged. It is merely bridging finance for adjustment.<$F Is it seriously thought that the adjustment now required of Mexico - in exchange for the $50b financing that it received - is really a soft option, the existence of which would encourage other governments to pursue a similar path?>

Restructuring and New Management

Many argue that a central problem is moral hazard. In corporate bankruptcy there is the sanction of throwing out the management; that is not possible for sovereign governments. But the sanction of being ‘put into the IMF hospital’ provides a guardian against the moral hazard problem. Financing is only available as a result of agreement on an adjustment programme, which is the sovereign government equivalent of restructuring.

Balance Sheet Restructuring

There appear to be two alternatives when the burden of debt appears too large, i.e. when the volume of debt obligations outstanding is so large that the adjustment necessary to achieve solvency appears impossible.


(a) Balance sheet restructuring can be imposed. (Note the well known collective action problems in achieving this without some administrative agency). It is of course true that the perceived possibility of write-downs can create moral hazard problems, borrowers will take less care if they believe that it is likely that in future a write-down will be available. Also, lenders might require a future risk premium, which can create inefficiencies in the future if there actually is intention to repay in the future (i.e. in such an environment how can an honest borrower signal intention to repay?). Nevertheless the costs of these problems have to be set against the alternative in which there is default with no agreed balance sheet write-down. That leads to borrowers being locked out of capital markets. And, given the high rate of return, that is clearly dynamically inefficient: over a long enough period of time the gain from default (the refusal to pay interest and or capital owing) will be more than offset by the loss on investment opportunities blocked.<$F This set of issues was discussed endlessly in the 1980s. How long is the lockout? Can the debt be eventually dealt with, so as to allow new debt, without full repayment? > One way of orgainising the restructuring may be to give the creditors direct control over some of the soverign borrowers assets (as has been done to the US government with the Mexican oil reserves, but more generally).

(b) There may be a third-party rescue. In the sovereign government case this is only likely if there are obvious gains to the rescuer due to (i) systemic risk or (ii) an appraisal by the third party that balance sheet write down would be bad for its own interests.<$F Mexico does not belong here. In the terms used here Mexico received financing, not a rescue.> Note that the possibility of rescue creates incentives for the lenders to hold out against alternative (a). It creates its own form of moral hazard among the lenders: they may not take due care in the belief that rescue is likely.


The brief review suggests that the issues as to what is best to do are complex and subtle, but that some institutional mechanisms are required if mere default is to be avoided. These may well differ from circumstance to circumstance (which of course makes it very hard to price the risks of obligations being written down).

Notice of course that the larger the proportion of explicitly risk bearing capital which the sovereign issues, the less vulnerable it will be to the risk of being insolvent on current policies. That is the thrust of proposals to limit the proportion of interest bearing capital which sovereign governments issue.

3.3 Improved Policies

Damping the Boom


Preventing the initial boom from being so large is important. But the shock due to liberalization seems generic to the problem, and commitment to policy reform seems to imply commitment to put up with such a shock. Graduation of reform may hold a key, as may a willingness to contemplate fiscal austerity and/or other policies to promote saving as part of the reform process. By limiting the shock at the first stage of the above process could mitigate the problem.

Allowing the Adjustment

The above suggests that a choice last March should have been made between soldiering on with the fixed exchange rate, and accepting the uncompetitiveness and higher interest rates – and the resulting slump – or depreciating the exchange rate and accepting the damage to the credibility which would have followed. The decision to delay was what turned an adjustment problem into a panic.

Floating the Rate

It may be that a floating exchange rate regime is better than a fixed exchange rate regime for this purpose. In such a regime there are temptations to pursue overvaluation parallel to those with a fixed rate. But there are not temptations to throw a finite reserve stock after the defence of a fixed exchange rate, to the point where the asset base of the financial and banking system is lost.

3.4 Other Issues

Information


The mere provision of better information, although desirable, cannot solve the above problems. The above argument rests on intrinsic risks. Poor information can of course increase those risks. It is now proposed that the IMF produce a list of what is required for release into the market. The hypothesis is that making available information will encourage others to do the necessary analysis. There remains a public good problem here, and there remains the possibility of herd behaviour if the necessary analysis is underproduced. Information provision on its own does not seem enough.

The Private-Public Split

One response to the above problems might be to privatise as much as possible of the public sector: in order to get as much of the foreign capital inflow at the time of liberalisation flowing into the private sector, in the form of risk-bearing equity. This is a slightly odd argument about the appropriate public-private spilt. And anyway, it does not guard against the fact that sovereign governments may be forced into rescue operations; i.e. that some of the risk may end up with them again even if this route is pursued.


4. A Tobin Tax?

One oft-mentioned potential reform of the international monetary system is the ‘Tobin tax’ – a small internationally-uniform tax on all international movements of capital funds. (See Eichengreen, Tobin and Wyplosz, 1995.) Such a tax is directed towards reducing the returns to footloose, rapidly moving speculative funds, without greatly penalising the returns to long-term investment. The tax works in the required direction since, the longer funds remain in the place to which they have moved, the smaller proportionate burden is imposed by the tax.

But having set out a series of hypotheses about market failure above, it is not clear to me in what way such a tax would go towards addressing those market failures. This scepticism is different from, and complementary to, that expressed by Garber and Taylor (1995). It does not appear to address the risk sharing agenda at all. And it would necessarily be at much too small a rate to make any difference to the kind of capital withdrawal which a short-term financing facility would be designed to deal with. It is therefore not clear to me that such a tax would have a part to play in the kind of reforms contemplated here.



References

Eichengreen, Tobin and Wyplosz (1995) ‘Two Cases for Sand in the Wheels of International Finance’, Economic Journal, pp 162 - 172

P Garber and M P Taylor (1995) ‘Sand in the Wheels of International Finance: a Skeptical Note’, Economic Journal, pp. 173 - 181

J Hicks (1967) ‘The Hayek Story’, final chapter in Critical Essays in Monetary Theory

P Krugman (1979) ‘A Model of Balance of Payments Crises’, Journal of Money, Credit and Banking, vol 11, pp 311 - 325

M Obstfeld (1994) ‘The Logic Of Currency Crises’, NBER Working Paper, no 4640

F G Ozkan and A Sutherland (1993) ‘A Model of the ERM Crisis’, mimeo, University of York

J Sachs (1995) ‘Do We Need an International Lender of Last Resort?’, Frank Graham Lecture, Princeton University, April 1995

J Sachs, A Tornell and A Valasco (1995) ’Lessons from,Mexico’, mimeo, March 1995

D Vines (1995) ‘Improving the International Monetary System in a World of High Capital Mobility’, mimeo, March 1995

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